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You Are About to Make a Bad Investment

What to avoid in today's market.

Don't you invest in that just because it's popular right now. I'm warning you.

Across 10 asset classes, over a near-40-year time horizon, and in increments of three, five, and 10 years, there's one investment vehicle that made for a total loser -- a dud.

It's gold -- that blisteringly hot preciously metal -- and if you're considering it today, let me explain why you need to bypass it and move on. Although gold may well be one of your favorite items in the vault, as a long-term investment, it is just plain lousy.

Bring on the hate mailYou needn't take my word for it -- Investor's Business Daily (log-in required) pulled the data from a study conducted by two Merrill Lynch strategists. And today, very few have the gumption to say that gold is simply not worth your time. Why?

Perhaps because, as IBD wrote, "In one recent five-year period -- the one ended Feb. 7 -- [gold funds] leave a different impression. Gold funds tracked by Lipper Inc. cranked out an average annual return of 25.45% vs. U.S. diversified stock funds' 12.60%."

You can bet your bottom dollar those returns have a lot to do with the metal's current popularity. As usual, investors are chasing performance. While gold funds and industry giants such as Newmont Mining(NYSE: NEM) are doing fine these days, four decades worth of data demonstrate that gold is a riskier and lower-returning investment than pretty much any other.

Higher risk/lower rewardThe two folks at Merrill hit the nail right on the head when they said, "Investors often lose sight of longer-term historical investment results, especially during short-term periods of extreme volatility and trending markets."

Bingo!

Short-term, return-chasing investing is precisely what is driving this modern-day gold rush and that is exactly why you should be looking elsewhere right now. But before I get to where exactly, it is important to understand just what the gold bulls are thinking.

Looking through the other sideSupporters of gold like to note that the past 40 years were an unprecedented period of growth in the American economy. We witnessed the rise of the quintessential American business -- names like Intel(Nasdaq: INTC) and Microsoft(Nasdaq: MSFT) and other companies that revolutionized or invented their industries alongside booming growth in our domestic economy -- the likes and returns of which we'll probably not experience again. OK, this may be true.

Gold bulls go on to suggest that there is no reason to believe that the next 40 years of equity returns will look anything like the prior 40. Our economy is too big and too developed ... and that's probably true too.

It's all about riskAccording to them, we're entering an era of massive economic risk thanks to our miserable levels of national and personal debt. As evidence, Wachovia(NYSE: WB), a cornerstone of our nation's financial industry, has nosedived more than 60% in the past year alone. Hey, don't forget about political risk from terrorism, a more competitive China, and the end of cheap fuel. Risk is everywhere.

To that I say: Where did the risk ever go?

Wasn't it difficult for Americans to buy shares of General Electric(NYSE: GE) during the height of the Cold War and with the underlying threat of nuclear war? Yet investors that stuck with their guns on GE made 11,328% (15% annualized) compared to a measly 385% (4.8% annualized) on gold since the start of 1975.

With all the bear markets, through the oil crises, Black Monday, the implosion of the dot-coms, stagflation, and all the economic risks you can think of, do you know which asset class was the only one that lost money in a 10-year time frame? Yup, our favorite precious metal: gold.

Goldfinger will not be pleasedI'm not bashing gold simply to bash. In fact, it isn't the worst idea to put a small slice of your portfolio in gold to diversify in case I'm wrong. But there's a better solution for the rest of your money: Go with the asset class that has consistently demonstrated the highest returns on investment with some of the lowest elements of risk: small-cap stocks.

This isn't my own unproven theory -- the data comes from the same study I mentioned before. Generally, equities trump just about every available investment alternative you have. But small caps in particular demonstrate significantly high returns with comparatively low risk. What more do you need?

The truth will make you richTo find the best of the small-cap world, you've got to think like a great small-cap stock. Remember: the giants of industry you know today once resembled the NVIDIA's(Nasdaq: NVDA) and the Under Armour's(NYSE: UA) of the world we know now. And though our economy has matured, great companies will inevitably find their way to the top of the U.S. markets, displacing others if they have to.

That's because many of the world's best businesses -- like NVIDIA and Under Armour -- started small with great ideas on top of cash-generating business models with entrepreneurial owners at the helm. And there are plenty more out there where those came from.

If you want to be on the side of returns that smash gold in the long run, then you must allocate toward these types of stocks.

Need some ideas? Consider our Motley Fool Hidden Gems small-cap service, where our team's picks have beaten the market by 22 percentage points on average. Click here to get all of our research and recommendations free for 30 days.

This article was first published July 8, 2008. It has been updated.

Fool analyst Nick Kapur used to have a gold class ring, but, sadly, lost it. He owns no shares of any company mentioned above. NVIDIA is a Stock Advisor recommendation. Under Armour is a Rule Breakers andHidden Gems selection. Microsoft and Intel are Inside Value recommendations. The Motley Fool owns shares of Under Armour and has a disclosure policy.